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Earlier this year, American Express chief executive Harvey Golub and Citicorp chairman John Reed sat down to discuss a possible sale of Amex to Citicorp. The two men and their lieutenants and advisers talked over joining the US’s largest bank (by market capitalization) with the world’s most famous credit card brand. In doing so they briefly contemplated what would have been the largest-ever M&A transaction. A purchase price for Amex of between $90 and $100 a share – and it would probably be closer to $100 – would imply a $40 billion deal. Amex looked attractive. Citicorp is keen to develop asset management, recently hiring Peter Carman from asset manager Putnam Investment to build business in that area. Amex is strong in asset management. But to progress from talk to action, the two sides would have had to find a way around the obstacle of Citicorp’s existing relationship with Visa and MasterCard, which prohibit banks from issuing rival cards.
Actually doing the deal raised even more awkward questions, involving not so much business fit and strategy as politics and personality. Golub and Reed are both 57, and both enjoy formidable status and reputation and are well used to power and autonomy. Could Golub join Citicorp in a high enough position – president perhaps and effectively number two to Reed – to satisfy him? High-profile outsiders have not fared well after joining Citicorp’s top ranks. Alternatively, could Amex become a separate subsidiary of Citicorp with Golub still in charge? If Reed had taken that course, he might then have had to forego any cost-savings from eliminating overlap. That might have made the acquisition excessively dilutive and even have halted Citicorp’s share repurchase programme, itself an article of faith between Reed and the bank’s shareholders, enshrining his commitment, following the mistakes of the 1980s, to keeping up the stock price.
The deal didn’t happen. “But it should have done. It made sense,” insists a source close to the talks.
Getting the structure right
Bob Khanna, head of corporate planning at Citicorp, is more cautious: “Our view is that there is a role for acquisitions for us only to the extent we require something specific, for example, locking in a low-cost production position or market access in a particular area. It is no secret that we look at things in emerging markets.” He adds: “With regards to something big in the US, we would have to be very clear about what it brought to the table.”
Despite such protestations, some outsiders still expect the Amex deal to go through, once the right structure is found. “It’s too powerful a combination to let slip,” says UBS’s Thomas Hanley, Wall Street’s top-ranked bank analyst. “It will take place before the end of this year.”
The general prospect is one of an upcoming frenzy of bank merger activity in the US. In a clear sign of things to come, NationsBank smashed the previous record price for an acquisition, announcing at the end of August that it would acquire Florida-based Barnett Banks for $15.5 billion. Hanley believes that even if the Amex-Citicorp deal doesn’t come off, the dam is about to burst and there will soon be a flood of huge bank mergers. “Between now [late July] and the fall,” he says, “the amount of bank-to-bank deals will be staggering and the size of banks being bought is going to continue rising. We will reach a point later this year, or maybe next, when $20 billion deals are not uncommon.”
For that to happen, some of the banks that are renowned as acquirers, even those as big as Banc One, now the US’s fifth-largest by capitalization ($28 billion at end-June 1997), will have to begin considering selling themselves to or merging with other, larger, super-regional competitors.
For most of this year US banks have appeared more intent on buying medium-sized securities brokers in an effort to gain a foothold in the lucrative primary equity market than on striking huge deals with each other. Announced bank acquisitions of brokers include Bankers Trust buying Alex Brown ($1.7 billion), NationsBank buying Montgomery ($1.2 billion) and BankAmerica buying Robertson Stephens ($540 million). In addition three foreign banks have acquired US brokers – CIBC Wood Gundy purchasing Oppenheimer for a total of $525 million, SBC Warburg acquiring Dillon Read for $600 million, and ING acquiring Furman Selz for $600 million.
Bank mega-mergers, comparable to the 1995 combination between Chemical Bank and Chase Manhattan, have not been plentiful. Even when they have not been buying brokers this year, America’s most acquisitive banks have been buying other non-bank businesses. For example, Banc One announced a $7.3 billion stock-swap deal to acquire credit card specialist First USA.
That’s not to say that conventional bank-to-bank mergers have stopped entirely. There have been some sizeable and high-priced acquisitions by regional banks. At the start of the year, First Bank System bought Oregon-based US Bancorp in a deal worth $9.1 billion. The banking market in Virginia was transformed in a matter of a few weeks in June and July as Wachovia bought Jefferson Bankshares (for $542 million) and then Central Fidelity Banks (for $2.3 billion). Then, shortly after, First Union acquired Virginia-based Signet Banking Corp for $3.6 billion or 22 times estimated earnings per share. Suddenly, Wachovia and First Union are the dominant banks in Virginia.
Merger advisers say that the precedent of First Union’s paying 22 times EPS for Signet has suddenly made feasible many other acquisitions banks have been considering but where the obstacle was price. The second half of the year is often busier for merger announcements – senior executives on the selling side know they are guaranteed another full year’s pay if they time things this way since it takes at least eight months to clear a typical merger deal past shareholders and regulators.
But the biggest US banks have been quiet for some months now.
To observers like Christopher Flowers, managing director at Goldman Sachs, this is the calm before the storm. “The biggest deals in the US will be banks merging with each other,” he says. “This is a long-established trend and we are now entering a late phase. This has been going on for a dozen years and will continue for five or six more years yet. And there will be some gigantic mergers.” Kendrick Wilson, managing director of Lazard Frères in New York agrees: “In financial services generally, standing still is not an option. You have got to either buy, sell, or sharpen your focus.”
Coast to coast
To date, no US retail or commercial bank covers even half the country, but several are working towards the goal of creating a nationwide bank. “The day of true nationwide banking is right around the corner,” claims Hanley, who predicts that the first large deal between an east coast and a west coast bank is no more than a year or two away. “Even when accomplishing these recent non-bank deals, bank managements still have their eye on that goal,” he says. “Whereas two years ago the bank M&A market was strictly bank-to-bank deals, and often one-off deals, today bank managements are thinking one or two steps ahead with each new acquisition.”
Prettying up
Hanley’s thesis is that the strategic planning behind some of these recent highly priced acquisitions of non-banks will become clearer when US bank consolidation enters the end game of giant combinations. Then, the other non-bank businesses that a bank has managed to acquire – equities brokerage, asset management, credit cards, mortgages – may be essential features making one bank appear a more favourable merger partner than another. Take Bankers Trust. The Hanley view is that the reason Alex Brown was bought was not because Bankers’ CEO Frank Newman believed it would propel the firm into the top bracket of global wholesale and investment banks but to make the bank more attractive to an eventual partner. “It’s a prettying-up move,” says Hanley. “Newman is going to sell it, probably to a Canadian or a European banking institution.”
Similarly, Banc One buying First USA to make itself much stronger in credit cards may be designed to enhance its appeal when and if it ever decides to sell out.
BankAmerica, the clear leader on the US west coast, might well be the most sought after partner in any definitive nationwide bank merger. Potential partners, such as Chase and NationsBank, might well be wondering what to acquire next in order to make themselves more attractive. That might lead to the acquisition of similar businesses, which would allow for post-merger cost savings, or different businesses to provide complementary strengths. NationsBank and BofA have both just bought medium-sized securities brokers. Could they eventually be merged to cut costs?
Meanwhile BankAmerica clearly lacks asset-management capabilities, although Robertson Stephens has brought with it, as well as equity brokerage, some highly regarded investment managers.
In any talks with a merger partner, BankAmerica would probably start from a position of strength. It moved into the midwest two years ago with the purchase of Continental Bank. Now some analysts are suggesting that the next move for Hugh McColl at NationsBank would be not to rush straight into talks with BofA but first to acquire First Chicago. That would add an overseas wholesale banking franchise and might also enhance McColl’s negotiating position if it ever came to talks with BankAmerica CEO David Coulter. “Believe me,” says an investment banker who knows NationsBank well, “Hugh McColl intends to go out in a blaze of glory. He has at least one more major deal in him.”
Looking even further forward, US banks may eventually go shopping abroad. Whereas it is hard for European banks to acquire in the US, because US banks have returns on equities up to 19% or 20% and European ones have 12% or lower, US banks in two or three years’ time will be so large they will almost have more capital than they know what to do with. “Today’s $300-billion-asset banks will soon be $500 billion. They will almost be compelled to look overseas,” says Michael O’Hanlon, managing director at Lehman Brothers. In the late 1980s, Citicorp looked at some second-tier British banks, such as Yorkshire Bank, but did not buy. That idea’s time may come again.
Before any such giant bank deals are struck, it seems likely that the consolidation of banks and securities firms in the US will progress further. Jerome Kenney, executive vice-president at Merrill Lynch, says: “Our guess is that in the US, most securities firms eventually will be owned by banks or other large financial intermediaries.”
Banks are typically larger than their peers in the securities industry. “Whether you look at it by market capitalization, earnings or whatever measure, the country’s banking system is eight to 10 times bigger than the top securities firms,” says Thomas McCandless, analyst at NatWest Markets. In February 1997, on the eve of the recent acquisition sprees, the market capitalization of the top 50 banks in the US was $513 billion, while that of the 20 or so publicly traded brokerage companies was only $75 billion, even after the DeanWitter/Morgan Stanley merger. In 1996 the banking industry’s profits were $54 billion, while the brokers’ – in a record year – were around $7 billion. So, regulatory issues aside, the dismantling of barriers between different parts of the US financial services industry continues piecemeal – banks can get into just about anything they want to.
It seems likely there will be more deals. And it won’t just be a case of banks buying brokers. They will also invade asset management and, their ultimate goal, insurance. “Banks are going to be at the centre of financial services in the US,” says Hanley. “For example, insurance is a very inefficient business. If banks can take out the middlemen and apply their capital structures to insurance company balance sheets, the leverage and the potential for profit is tremendous.”
Squeezed margins
For the moment, foremost in the minds of many bank shareholders is the question why the managements of banks – a stock market sector where shares typically trade on a multiple of 14 or 15 times EPS – want to get into the brokerage business, where stocks have typically traded at eight or 10 times earnings because of the higher volatility of brokerage earnings. The answer is complicated but essentially comes down to the fact that banks’ own earnings growth is weak and their profit margins are being squeezed. “This recent bull market has masked a considerable deterioration in profits and margins, in lending spreads, and for that matter in other parts of the wholesale financial services sectors such as M&A, where high volumes have masked declining fees,” contends Lazard’s Wilson. He adds: “There is little revenue growth in financial services with the possible exception of the growing demand for certain savings and investment products as baby-boomers put their money into those investments.”
The future of balance-sheet lending doesn’t look good and banks have convinced themselves that they must be able to provide equity finance to companies in order to make money and protect relationships with corporate clients. “The banks which have recently bought securities firms have all said that in order to retain strong relationships with companies they feel the need to be in more chairman-level strategic discussions, and that requires equity underwriting and M&A advisory,” says Diane Glossman, analyst at Salomon Brothers. “Banks feel that if they are in with that very top level of company management it enhances their ability to sell other services.” She adds: “The flipside of this tactic for protecting relationships is the financial impact of getting into a low p/e multiple business.”
Once a bank has decided to get in, building equities business is not a particularly attractive prospect. “There is no shortage of equity underwriting capacity, so there is no natural advantage in just building additional capacity,” points out Jeffrey Goldstein, vice-chairman at BT Wolfensohn. And it’s not easy.
For their part, securities firms have been happy to sell out. Roaring bull markets have fuelled their own recent earnings and driven their stock prices higher. Banks are offering high prices and high multiples. What’s more, securities firms are also worried about losing business because of their own limited array of products. A firm that is good at just equity might eventually lose out in its dealing with middle-market companies to a rival that is strong at high yield and also has some ability to offer leveraged lending and equity underwriting. Hence the recent spate of deals.
NationsBank is an interesting example. Earlier in the 1990s, amid much fanfare, it built up a large investment-grade bond trading and underwriting business but began cutting back in that area last year, having decided the returns were poor. “NationsBank realizes that there isn’t much return in basic lending either and they will have to put up with single-digit returns on equity unless they can deliver higher-margin businesses,” says one analyst. A middle-market company looking for financing including $200 million of senior bank debt, $100 million of high-yield bonds and $100 million of equity, might be happy to take such a package from a single provider, potentially offering a high return to a provider like NationsBank. “NationsBank seems to have put its geographic expansion on hold while it fixes the return on equity,” says one banker. “Once it has figured out how to make more money from clients, its geographic expansion will be back on track.”
It’s very noticeable that the largest acquisitions of US securities firms to date this year have been made by US banks. As well as prettying themselves up for possible merger discussions, banks see a business logic to these deals that justifies them in their own right. For NationsBank and Montgomery Securities, this is an essentially US strategy. “NationsBank is the largest middle-market lender in the US,” points out Jerome Markowitz, senior managing director at Montgomery, “and all of our client base is middle-market.” As Markowitz sees it, each side brings something the other doesn’t have. The same thinking is behind BankAmerica’s deal with Robertson Stephens.
Acquisitions of securities firms will probably continue with regional banks in the US likely to be attracted to regional brokers, such as AG Edwards, Raymond James and Piper Jaffray, or to national retail-oriented firms such as PaineWebber whose retail brokers might be seen essentially as asset gatherers. There are plenty of US regional banks with section 20 securities subsidiaries – First Union, PNC Bank Corp, Bank of Boston, National City – that might be in the market for such brokers.
The acquisition trail so far has led banks right up beneath the bulge bracket, but banks have stopped just short at the top second-tier firms like Alex Brown. Most of Wall Street is wondering whether the larger firms – DLJ, Salomon, Lehman – might be next, or even the very large firms, such as Merrill Lynch, Goldman Sachs and Morgan Stanley. Whereas the Bankers Trust/Alex Brown deal compelled many smaller securities firms and banks to act, the top firms have so far been above the fray. “The acquisition of middle-tier securities firms are relevant mostly to each other,” says Flowers at Goldman Sachs. “But though the top firms have been less affected, dramatic combinations of one form or another are likely.”
Delicious speculation
Guessing the combinations is a game of delicious speculation for many on Wall Street. Would, as some suggest, Merrill Lynch ever combine with JP Morgan, putting together Morgan’s great corporate relationships and Merrill’s great prowess in securities markets? Several rumours have suggested it. How about JP Morgan and DLJ, as others prefer. Morgan has done a good job of growing in equity, but the bar is being raised all the time. It would not want any deal that would disrupt its highly prized culture. DLJ is smaller than the top-three securities firms and not international. It might give Morgan a boost in equity and, as reputedly the best-managed large securities firm, it might fit the Morgan culture.
This is not a game that Merrill’s Kenney, for one, seems inclined to play. “I don’t think Merrill, Goldman or Morgan Stanley need to merge,” he says. “At Merrill we have $300 billion of assets primarily related to securities: that’s more assets than JP Morgan. Last year we earned $1.6 billion: that’s more than Deutsche Bank. Our market capitalization is bigger than SBC’s. Our credit rating is AA, better than many banks’. We have $100 billion in money-market funds off balance sheet, which is our version of deposits.”
The largest securities firms are in any case playing in a different arena than are the very large but essentially domestic US banks. It wouldn’t make much sense for NationsBank to buy a global securities firm like Salomon Brothers, even if it could afford to do so. As Kenney points out, the top three US securities firms would be very big acquisitions indeed. The market capitalization of Morgan Stanley DeanWitter is about $30 billion.
Goldman Sachs is a firm rivals love to watch and speculate about. In the past, former employees recall, it has cooperated informally with PaineWebber on distributing deals that required a greater degree of retail coverage. But a merger with a retail firm seems unlikely. As with many of its larger peers, Goldman is striving to build asset management. In one rival’s view: “Of the three largest firms, Goldman has the biggest problem: its high-cost capital structure. Almost one-third of its capital is fixed-rate preferred owned by institutions which has to be serviced no matter what its profits. It has huge compensation demands and demands on its capital from limited partners, so it has the weakest capital generation of the largest firms.” Then there is the question of whether it should go public first, then do a merger, or do a merger first, or do none of these. But Wall Street deal-makers seem keener on the idea of floating Goldman publicly than marrying it to a merger partner.
Few Wall Street observers doubt that the large firms below Goldman, Merrill and Morgan Stanley will end up merging or being acquired. As banks busily acquired second-tier securities firms this spring and summer, the air of expectation among the larger, institutional securities firms grew ever more palpable. “At some point relatively soon, we will see acquisitions of the larger investment banks. I don’t think there is any doubt about that,” says Robert Smith, managing director at Salomon Brothers. Employees at Salomon now jokingly ask each other whether they think it’s a better idea to be learning Dutch or German.
Everyone in Wall Street agrees those firms must do something – they differ on what that should be. Should they merge with each other (there have been rumours of a Lehman/Salomon merger and a Salomon/ Goldman merger), find a foreign buyer (Dresdner Bank and Lehman is just one of dozens of recent rumours) or be bought by a US bank?
At Lehman Brothers, employees have grown so used to hearing that the firm has been sold to Chase that they sometimes jokingly ask visitors to their offices in the World Financial Center if they have been sent down by Jimmy Lee to look them over. Those closer to the head of Chase’s investment banking business say he is talking of building an equity business, starting by hiring top-ranked analysts, and that Chase may not be in any hurry to buy a securities firm. One senior Chase executive says: “In the longer term we need an equities business. But we don’t see any short-term crisis from not having it. We’re making a lot of money in our other wholesale businesses: lending, derivatives, forex, custody. We’re not going to be stampeded into anything. We are aware of our alternatives in equities and at some stage one of them – buy or build – will hit. We’re closer to build than we were a year ago.”
The problem for Chase is that it is a global wholesale bank with 40% of its revenues coming from outside the US. A firm like Montgomery wouldn’t be much use to it. A firm like Lehman brings excess baggage and a lot of overlap, particularly in bonds, for which both Lehman and Salomon are still more renowned than either firm is for equities. There is no such thing as a top-rank global equities market boutique. If there were, banks like Chase would be prepared to kill to get hold of it.
And some inside Lehman argue that the longer the firm remains independent the more attractive a place to work it will appear to be for those fleeing from new bank parents. But again, the sense of expectation is growing. “If you asked me to put a likely order on it, I would say PaineWebber will go first, then DLJ, then Lehman and then Salomon,” says a banker at a bulge bracket firm.
Acquisitions of middle-tier firms are now commonplace. When CIBC Wood Gundy finally bought Oppenheimer, after weeks of speculation, the news caused scarcely a ripple. What would generate huge excitement would be a foreign bank buying a larger securities firm.
Foreign interest
Foreign banks have sniffed around some of this year’s deals. ING was disappointed that it lost out on Montgomery. Société Générale was also keenly interested in Montgomery and only pulled out at the last moment, following the outbreak of disapproval among NatWest shareholders over losses and incoherent strategy at NatWest Markets. SBC Warburg had been an early suitor for Montgomery. Though SBC Warburg eventually bought Dillon Read, essentially a corporate finance specialist, that did not provide it with the decent-sized US equity business it needs to compete in the global capital markets with Goldman, Merrill and Morgan Stanley. It may still need to acquire one.
Rabobank looked at Greenwich Capital before it was purchased by NatWest. ABN Amro is a bank that many expect to make some move. Similarly Dresdner Bank recently announced a capital-raising to fund growth outside Germany, possibly via acquisition. Dresdner is one of the long list of banks rumoured to have looked at Lehman Brothers. “What would be very significant for other firms aspiring to leadership in the global markets would be a large foreign bank making an acquisition as part of a credible straegy,” notes Lazard’s Wilson.
Some larger banks are not as obsessed with breaking into the US securities markets. HSBC has recently declared that it is more interested in repeating its Asian success in the growth markets of Latin America. Banco Santander is placing its bets on the same region. It’s a regional strategy, in contrast with the – so far – national strategies of NationsBank and Bank of America and the global strategies of Merrill Lynch, Morgan Stanley and a few others. Other banks that were once aspirants to leadership in global securities are fading, such as, most recently, NatWest. Many have fallen by the wayside in recent years: the Japanese brokers, like Nomura and Daiwa, and UK merchant banks like Warburg.
Retreating from such grandiose ambitions may be no bad thing for banks. Ten years ago the largest European banks by market capitalization were first UBS and then Deutsche. Today it is first HSBC and then Lloyds TSB. Lloyds was the eighth-largest European bank 10 years ago. It has succeeded by focused acquisition, ignoring the attractions of international markets and investment banking. UBS now limps in as Europe’s ninth-largest bank, while Deutsche is fifth.
But for banks like Deutsche and UBS, which are used to dealing with large corporate customers, a managed retreat would be difficult. The question remains whether other banks will make it. “We see in the final hierarchy six to 10 top-tier global firms competing with us in securities, asset management and private banking,” says Merrill’s Kenney. “The majority of those will probably be banks.”
To be in that group will demand a decent-sized US securities business. Chase clearly sees itself in that group, as does SBC Warburg. Who else? “If ABN Amro bought Salomon Brothers, that would be a big change,” acknowledges Kenney, “though of course, it would have to manage it.”
Mood and psychology
For the moment the large US securities firms are not losing much sleep at the sight of UBS and Deutsche hiring individuals at high salaries. “It would only take one major acquisition to change that,” says Douglas Mercer, managing director at DLJ. “That might make the other large investment banks think they have to act.”
Much may yet depend on the mood and psychology of senior management of the large US securities firms. That may determine their fate. A foreign bank “would probably be able to pay much more for a Salomon or Lehman and would give their existing management more latitude”, suggests UBS’s Hanley. “And what with a high price and some operational independence that might be very attractive for them.”
